BERKONOMICS – Business insights from Dave Berkus

Ignition! Starting up

Don’t get hung up on valuation.

by on Jul.10, 2014, under Ignition! Starting up, Raising money

I can’t tell you how many times I’ve walked away from deals where the entrepreneur insists on a start-up premoney valuation that is so high, no angel could expect to make a return upon the investment, even with a reasonable sales price for the company down the road.

Raising_moneyThere is always another attractive deal at the ready, and most have reasonable expectations of valuation. Why fight about valuation, or disappoint the founder at the outset? The real focus should be on smart planning, finding ways to launch and build the business with smart but frugal use of money.

Let me tell you two stories that are linked. The first is of a 2004 startup that I cofounded and led the investment group for several early rounds, then VC rounds. The company has grown to forty employees and a healthy eight figure gross revenue run rate, but has absorbed over $36 million of angel and VC money to do so, and without yet reaching breakeven.

[Email readers, continue here...] The second story involves a founder who is using outsourced development, support, outsourced customer relations and more. The total capital raise will have been under $600,000 if all goes as planned, and the founder retains majority control of his baby through this and even one optional future round.

For the first, company, the founder’s remaining portion is under 4% after all the subsequent rounds, and not yet at breakeven. The second company finds the founder with majority control even if the original raise is not enough. For the founder to see any return at all in the first company, the ultimate selling price must be above $40 million. In the second company, better planned, the founder would be made pleasantly wealthy at a selling price of $10 million. The chances of the latter occurring are much greater than the former. This founder was not hung up on valuation for the second company, just upon efficient use of capital.

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The Rule of Thirds

by on Jun.12, 2014, under Ignition! Starting up, Raising money, Surrounding yourself with talent

It is rare when one person starts a company, supplies all the funding, and shares no management tasks or equity with others, and still grows the company to any significant size, worthy of a multi-million dollar opportunity to cash out at exit.

We should think of the creation and growth of a high valued company as the sum of three parts, with three distinct classes of participants helping to make real value out of a raw start-up.

First, there is the entrepreneur, the visionary, and force behind the venture from start to finish. The reward for the entrepreneur, after years of effort, time and sacrifice, is measured by EA-9817what portion of the total pie s/he retains at exit, how much the person continues to participate through that time, and how many other resources are brought in to get to that point. Most importantly, the reward is measured by how much added value the total process creates over time. It is the old story of “100% of nothing is worth far less than 10% of a large number.”

[Email readers, continue here...] Few entrepreneurs can do it alone, with subordinate hired help and no expert management to share the burdens, skill sets and efforts involved in growing the enterprise. So co-management is the second group to share in the bounty upon a liquidity event. Often, if not co-founders, this group is rewarded through issuance of stock options from a pool of available options that usually totals 15-20% of the total company’s equity divided among all employees. Those who receive options but leave the company before a liquidity event may either purchase those shares represented by the options upon exit from the company, or lose the right to those shares, often 60 days after their exit.

The third group is made of the total number and types of investors, other than the founder(s). From friends and family early on, to angels that are not related to the founder(s), to venture capitalists for larger opportunities, these investors have risked their money in the venture for only one reason – to eventually profit from a liquidity event.

It is normal for the first round of organized angels to expect to purchase between twenty and thirty-five percent of the company with their investment. Second rounds, if needed, often drive the founder(s) into a minority position, unless the company has grown significantly by that time and can command a higher pre-money valuation, giving less stock for the same amount of investment. Investments in small companies involve a much greater degree of risk than investment in public companies, which provide immediate liquidity if needed and a ready measure of value at any time. That risk deserves reward if there is a profitable sale or even an initial public offering, rare as that event is.

So remember that there are three slices to the pie to consider when creating your company and again when considering a sale or liquidity event. All three deserve recognition for the risk, time and effort in driving the company to its ultimate value.

Think of it as the rule of the thirds.

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Huge opportunities do NOT command amazing pre-money valuations.

by on Jun.05, 2014, under Ignition! Starting up, Raising money

Dave’s note: Popular Bill Payne returns this week with a thoughtful take on valuations.

By Bill Payne

One entrepreneur has a company which appears to be scalable to a $30 million exit value in five to eight years, and a second entrepreneur’s venture seems to be scalable to $200 million in exit value in the same time frame. Yet, at the pre-revenue stage of development, angel investors price both companies at a pre-money valuation of $1.5 million.

It doesn’t seem right, huh?

Bill PayneBut, it is… and here is why. It is possible to grow a company to a valuation of $30 million on one or two angel rounds of investment. But, the working capital and management team necessary to grow a company quickly to sufficient revenues to justify a $200 million valuation will require raising lots more capital. So, the angels who provided the most valuable and risky financing for the gazelle that can grow to a $200 million valuation quickly are going to get diluted by subsequent investors, probably by three to five-fold. They may own 30% after the first round of funding but will probably own less than 10% at exit. So, angels simply must value both ventures at about the same price.

[ Email readers, continue here...] Scalability is a critical factor for angel investment. Because of the risk inherent in funding pre-revenue companies, angels are unlikely to invest in any venture that cannot demonstrate the potential to scale to a $20-30 million in valuation in a reasonable time period (5-8 years).

So, angels won’t fund a deal that doesn’t scale sufficiently to justify investment, and they tend to value all pre-revenue stage companies at about the same valuation, which is currently about $1.5 million in most parts of the US. Although there may be some variation among business sectors, this is essentially true for software companies, medical device companies, life science ventures, electronics companies and alternate energy deals, regardless of the long term potential.

 

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Craft your roadmap. Plan your trip.

by on May.29, 2014, under Growth!, Ignition! Starting up, Positioning

By JJ Richa

J.J. Richa is a successful entrepreneur and technologist giving back to the entrepreneurial community in many ways, including his weekly Internet TV program on entrepreneurism, and participation in several mentoring programs.      

Business planning is a crucial part of a successful business. Business plans are dynamic instruments used on a regular basis to help owners and executives to plan for future growth, and

From Basic Berkonomics: Available Amazon, B&N,  berkus.com and booksellers everywhere.

From Basic Berkonomics: Available Amazon, B&N, berkus.com and booksellers everywhere.

assess past performances. Included in a business plan are financials, competitive landscape, marketing plans, and projected sales to name a few. Without a business plan, you probably are not sure where you are going, or how you are going to get there, or how you are going to know where you’ve been. If you don’t know these things, how are you going to course-correct if things go differently than forecast?

A business plan:

  1. Organizes your thoughts to better run your business
  2. Depicts your roadmap/blueprint, and must be revisited often
  3. Defines your business vision, objectives and goals
  4. Determines financial requirements
  5. Keeps you on track to achieve your goals
  6. Helps you to be more focused
  7. Forces you to be more objective
  8. Determines feasibility
  9. Serves as management tool
  10. Assists you in raising capital

I’m not seeking a bank loan or investment. So why make a plan?

[Email readers, continue here...]  A business plan is yours alone. Bankers, financial institutions, and investors hardly look at business plans. But it’s a valuable document for you. By creating a plan you are forced to think about your business and how it is structured, the objectives and other critical matters. The plan helps an owner realize how interrelated all aspects of the business are. In addition, it helps you focus your ideas and determine how to best manage your available resources including capital, cash, and people.

After completing your plan, you should be able to answer questions:

  • Is there really an opportunity here?
  • Can we pull it off?
  • Can we make money? Is there potential for profits?
  • Where are we?
  • How did we get here?
  • Where are we going and how will we get there?

Forecasting your finances as part of the plan will help you understand if, and how, you can improve revenue. It’s hard to make changes if you don’t know where you are, and where you’ve been.

It helps other answer the following question:

  • Will they have a chance to succeed?
  • Can they pull it off?
  • Will the cash flow?
  • Did they make any headway?
  • What have they done so far?
  • Will they be able to execute and reach their objectives?

As your business grows, a business plan serves as a guide to help you track, monitor and evaluate your progress. Having your short-term and long-term goals written down and in front of you can help keep you on track to reach them. Business plans provide you with the ability to identify risks to your business and what alternatives exist to minimize them. By analyzing your business objectively in the plan, you can address problems before they escalate. Studies found that people who write plans are more likely to put their goals in action and increases your likelihood of success.

Business Plans are not static. As your business changes, your original plan may no longer be as relevant. Review your plan periodically – as often as once per month, but no less than once per quarter – and make updates as needed.

 

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How many innovations are carefully planned?

by on Mar.06, 2014, under Growth!, Ignition! Starting up

Most innovations come from responding to a customer’s needs, or finding a niche where products need improvement or extension.  It is rare to innovate using a blank sheet of paper in a room with bare walls and no other contributors.

Imagine the room in which several graduate business school student groups have gathered, tasked with coming up with an idea for a business plan competition.  The group starts with a blank sheet, and toils through idea after idea, trying to come up with a product or service that might become the next FedEx.  That is tough work, and not a very productive way to start a process.  Sometimes, the result is spectacular.  Most of the time, this form of thinking produces a plan that requires real work to imagine success.

I’d advise the students to do it differently.  I’d advise them to pick a growing industry.  Then find a short list of users, customers, and consultants in that industry who are known to be advanced in their thinking as demonstrated by their prior work.  Then I’d advise them to visit the CEO.  And ask, “What is it that bothers you most about your operation?”  “What is you biggest problem, other than working capital?” “Where’s your bottleneck in production or sales or development?”  “If you could invent a solution, what would it be?”

Dave's workshops

Dave’s workshops

[Email readers, continue here...]  Now that’s how to find pain in an industry.  And yet, few think to use this form of investigation.  Yes, you can argue that probably Fred Smith might not have thought of FedEx if he had just interviewed rail or postal customers.  But maybe someone would have given Smith the bare idea from which he could imagine a much bigger opportunity.

If you’re starting a new company because you have a better way to do something, create something or market something, you have a head start.  But if you’re trying to think of what you want to produce, start with finding the pain in the marketplace, and set out to remove it.

Henry Ford famously said, “If I asked my customers what they wanted, they would have said ‘a faster horse.’”  As a mechanical genius, even that comment might have led Ford to envision a way to provide reliable, fast, inexpensive, mechanical horsepower.  It is the process of leaping from a need to an eloquent solution that creates demand and ultimately success in the marketplace.

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Burn the bridges behind.

by on Feb.27, 2014, under Ignition! Starting up

By Frank Peters

I became an entrepreneur because I had to. My life in Corporate America wasn’t going so well.  I never got fired, but I did quit one job the day before I was to be let go. I used my employee discount that last day to purchase a Compaq luggable computer and drove with my brother to Las Vegas.  Now, this would be questionable therapy for anyone who just became unemployed, except we were heading to Comdex, the annual computer show that would eventually grow huge as would the industry itself.  I consider this trip the anniversary of the company’s starting up, and made the trip 11 years in a row.

How was striking out on my own? I’d often say: “I created the company so no one could fire me.”  I never took a business course, never wrote a business plan, and never raised any outside capital.

As I look back at insights I might share, I wade through the trite suggestions of ‘work hard’ and ‘treat the customer well.’  But there’s more.  Burn the CIMG1875bridges behind comes to mind.  I had no alternatives to success. I was not going back to corporate America. It wasn’t a fall- back position.  I had to be successful at my new software company. And it wasn’t easy.

[Email readers, continue here...] I remember taking a walk with my wife one evening and sharing my concerns over cash flow. My sales tax payments were due in the next few days, and I didn’t have the money.  Default would bring many consequences. But I did have an appointment, a sales opportunity the next morning. I woke up that next morning with a jolt – literally.  An earthquake struck Los Angeles.  In an hour I received a phone call from the friend who was in the office where I was due later that morning. He had made the introduction for my appointment. “People are pretty shook up here today.  Some were stuck in an elevator.  I don’t know if today’s the best day to come up.”  He wasn’t telling me I couldn’t come, so, because I had to, I did.  I made the sale, and paid my debts.  I always remember that ‘back against the wall’ feeling.  It was stressful and yet so typical when running a small company.

This morning over coffee, my wife told me of a dream she had last night. It was about the earliest days of our life together when we moved to Westwood so I could attend UCLA. “Moving out west away from our families was one of the best things that could’ve happened to us at that early age,” she recalled wistfully. “We had to make a go of it.”  It brought back the memories of landing at LAX in 1974 with three suitcases and $1,900 to our names. Like my eventual experience as an entrepreneur, we had to persevere.  We had no alternatives.  We had burned our bridges behind.

Frank Peters made his money writing software for Wall Street. Today he is best known as the host of the Frank Peters Show, delivered via the web each week to tens of thousands of entrepreneurs, angels and VCs worldwide. Frank speaks and networks at angel events around the world.

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It’s mostly in the execution.

by on Feb.20, 2014, under Growth!, Ignition! Starting up

“Everybody’s got a plan – until they are punched in the face,” stated boxer Mike Tyson.  My experience personally reviewing over three hundred executive summaries each year, all sent to me unsolicited, seems to bear out the truth in Tyson’s statement.  Anyone can build a good – or great – plan.  Investors have to look behind the plan and at the entrepreneur and his or her team, knowing that, over time, most of us have come to the conclusion that it is the execution of the ever-changing plan, not the plan itself that makes a company a success.

Tyson’s statement also addresses change.  The ‘punch in the face’ is analogous to dealing with the business plan when it intersects with the realities of the market.  Wham!  I can’t recall any of my companies hanging onto its original plan after some level of consumer feedback.

We built one of our companies upon forecasted metrics for a specific class of retail consumer base, but found that there wasn’t enough money in our universe to pay for marketing to create that much dedicated traffic to our site.  So we switched to distribution through partners which already had computer_dashboardmassive amounts of traffic, and concentrated in providing great content and great offers that more than made up for the sharing of revenues.

[Email readers, continue here...]  There is a name for such a change in focus, in this case from retail to wholesale.  We call it a “pivot,” a term now used to describe great management dealing with successfully refocusing a company in a new direction.

And most of us who invest in so many companies have come to the conclusion that our greatest profits over time come from investments in great management, groups that we are confident are able to execute even on average plans.   Some label this as “Bet on the jockey, not the horse.”

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The three step dance – creating a great company

by on Feb.06, 2014, under Finding your ideal niche, Ignition! Starting up, Positioning

Creating a gerat company in a relative vacuum is an exercise in complete trust that the entrepreneur knows what’s best for the customer, perhaps even without interaction with such a customer.  It’s probably happened, but not often enough to trust this method as a formula for success.

So, I’ve developed the three step dance in order to help form a repeatable method of how to create a great company from an early idea.

The first step: Involve potential customers early. Even if you know it all – wouldn’t it be an excellent plan to try your idea out on enough actual or potential customers to measure reasonable feedback?

You can use or discard the information you receive.  We now know that Steve Jobs created in relative secrecy several of his products that became massive industry drivers of change.  The iPad probably would have failed before production, had he used feedback and research from past failures of tablets in any previous form as a guide.  On the other hand, most products or services are created in response to a real or perceived need.  And most of us are not Steve Jobs.

[Email readers, continue here...]  The second step: Take feedback seriously.  Making the effort to gather metrics from the field in any form and then ignoring it, takes guts and determination – and in most cases a measure of stupidity.  As I analyze business plans, I usually ask the DBconsulting1entrepreneur early in the process whether s/he has tried this idea or prototype or mockup out on potential users.  And if so, what was the response?  And from how many people?  In what related universe?  I want to know that potential paying customers have been queried using enough information or a good enough model to get a real response worth taking seriously.  Without this, any information received is suspect.  And failure to make use of the information is a red flag for investors.

The third step: Reiterate and return to customers for comments. Seeking, then analyzing responses allows you to make changes to the plan and product in response.  But what if the changes create other problems for the customer, or miss the mark, or don’t drive these same customers to more positive responses?  The best possible second round feedback should come from the very same people who took the time to review the offering the first time. They have context and should see effort and progress.  Their comments should therefore be more valued than those from first-time respondents.

The three step dance:

  1. Involve your customers early.
  2. Take feedback seriously.
  3. Reiterate and return to customers for comments.

So, why not design your product using your real and potential customers as consultants?

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Ready, aim, fire. Really?

by on Jan.30, 2014, under Ignition! Starting up, Positioning, Surrounding yourself with talent

You’ve surely heard the variations on this theme.  “Ready, fire aim” was popular in the 1990’s, accredited to any of several authors.  I used the term to describe my efforts in the artificial intelligence field, experimenting with new devices, the lisp programming language, and our first trial installations.  It seemed an ideal way to describe a scrappy, entrepreneurial activity.

So why do so many business-book authors stress the opposite behavior? Ready, FIRE, aim. What happens to careful planning, sure-fire metrics, quality test scenarios, market research, a good business plan – all in place before pulling the trigger of a new opportunity.

And who is right here?

[Email readers, continue here...]  If you’re seeking investment from anyone other than friends and family, you’re probably going to have to navigate through the exercise of careful planning, documentation and execution.  Investors are a fickle bunch in general.  They want to know that DB Concordia2their money is not just being thrown at an idea that will become a trial by fire – literally.

On the other side of the argument is the truth of the claim that numerous iterations in the form of rapid prototypes and execution of new ideas in the field quickly refine the product or service to meet the needs of the customer, and at a far faster and cheaper pace than with careful pre-planning.

In the software arena, there is a term for this: “cowboy coding.” Without the need to carefully document the architecture and elements of a proposed application, a single programmer can much more quickly just code, test, and create revised code.  Without even pausing to document the process internally, no-one can easily take over the job, if for any reason the cowboy coder is no longer in control.  And the result? Typically, we call that “spaghetti code” to signify code that is so often changed that it no longer looks clean and traceable.

The conclusion is that the best process depends upon the product, its critical core nature to the business using it, and the way in which the entrepreneur approaches the need for outside investors.

Critical components of any operation or business must be carefully constructed, tested and inserted into the operation of the business.   On the other hand, if a new free iPad app has bugs, they can be corrected in the next automatic update, and probably without much customer noise.

Which is better for you: rapid iteration or careful planning?  What is your case for defending your method of creating new products or services?

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Build a company – not just a product.

by on Jan.23, 2014, under Finding your ideal niche, Ignition! Starting up, Positioning

Some businesses are built around a single idea.   And sometimes that idea is just too small a slice of the big picture to be interesting to investors.  There was a recent investor event where I was keynote speaker, on stage only after several panels of experts had wowed the audience with their predictions and observations.  One of the panelists made a point that resonated with me.

She stated that she had rejected the investment being discussed, because in her mind the entire company was “just a button, on a feature, in an app.”  That comment sent me thinking about relevance, about longevity, and about market size for some of these entrepreneurial applicants looking for funding.

If you have invented a game that will be marketed as a new app in the app store, have you created enough of a model to create an ongoing company, or just another app that will compete with the hundreds of thousands already in the store?  Is your game using a unique engine, or series of animated characters, or method of play that will break ground with potential players, inducing them to look to you for more and more unique games over time?

[Email readers, continue here...]  Far too many companies have been created around a button on a feature, and not upon a solution to a need in answer to a void in the market.  Investors have seen this game before.   We match what we see to what has succeeded for us in the past.  And rarely do we see a plan for a single product that is not part of a larger vision, and remain interested long enough to ask for more information.

There are exceptions.  The famously popular app, “Draw It,” might at first seem an exception, until you dig deeper to find a dense plan around a series of social engagement products planned to follow.   Can you extend your product into a planned series?   Plan to create apps, not buttons, and not features.

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